Looking at the Mortgage Interest Tax Deduction

When listing the benefits of home ownership, one of the most often cited "benefits" is that of the mortgage interest tax deduction. In the United States, individuals that itemize deductions on their tax return can include the interest payments for mortgages on their primary residence. This tax savings, many claim, is just one of the untold reasons why YOU NEED TO BUY A HOME TODAY!!!!1!1!!!!1!! In fact, some people are remiss to pay off their mortgage (and instead use their home like an ATM, refinancing to fund vacations, home improvements, pay bills, and so on) in part because they do not want to lose this precious deduction.

While any reduction of tax burden is nice, realize that this benefit is only seen if you itemize your deductions. The tax code provides a standard deduction for non-itemized returns (the amount varies on the year and the filer's marital status; for married couples it's near $10,000). Therefore, it only makes sense to itemize your deductions if they exceed this threshold. Deductions can come in the form of charitable giving, business expenses for the self-employed, alimony and child support, various educational expenses, and so on. While there are a number of deductions that might make it worthwhile to itemize, the plain fact of the matter is that many do not, meaning that they do not see any benefit from the mortgage interest tax deduction. (For example, if your annual mortgage interest is less than the standard deduction, and you have no other deductions, there's no benefit to itemizing.)

And even if you do itemize, you're still paying more than if you more quickly paid down your mortgage. For example, imagine that you paid $10,000 of interest per year to the mortgage company. You get to deduct that $10,000 from your stated income, meaning that if you made $70,000, you can now pay taxes on just $60,000. If you are in the 30% tax bracket, you just saved 30% of $10,000, or $3,000. However, you had to pay $10,000 to save that $3,000, meaning that you're down $7,000. Granted, being down $7,000 is better than being down $10,000, but the point is that the mortgage interest tax deduction is NOT free money and is NOT some wise investment move.

In my opinion, the wise move is to aggressively pay down your mortgage so that, sooner than later, you're paying $0 in interest payments to the bank. Granted, you'll be losing $3,000 in tax savings from when you were paying $10,000, but I'd rather lose $3,000 for free than have to pay the bank $10,000 in order to save that $3,000.

I/O & Option ARMs, Condos, and San Diego

Recently the O.C. Register held a real estate panel with the end result being not so surprising: the panelists were bullish. From the article:

Gary Watts, an economist and broker in Mission Viejo, was the panel member most bullish on Orange County. He said home prices will shoot up 15 percent next year. Walter Hahn, a consultant and real estate economist in Irvine, said the county should keep seeing double-digit gains in home prices until the next recession.

The O.C. Register's The Morning Eye blog posted some of the panelists' comments that
seemed more grounded in reality. In particular, Scott Simon's comments were most level-headed (and, at the same time, a bit scary):

Also, (Orange County) is the hub of creative credit in the world with New Century, Ameriquest, Option One, everybody’s here.

(As home prices rose, buyers) couldn’t afford the house anymore. You want the house and suddenly New Century or someone is saying, "Well, take an interest-only loan. Instead of paying the principal, you only have to pay the interest." Then you say, "I can’t afford the house now" and they say, "Don’t even pay the interest. Let’s negatively amortize the loan."

The really negative sign for us is the fact that, last year, 82 percent of the purchase loans in the state of California -- Orange County being representative -- were either interest-only or negatively amortizing loans. We view that not as an economic choice people were making, just simply an I-can’t-afford-the-house choice.

Eep. I've talked about option ARMs before, and how they are a recipe for financial ruin, and how San Diego county led the nation in the highest percentage of interest-only loans in 2004, but I didn't realize that 82 percent of all loans in California were of one of these two varieties of "evil" loans. Scott Simon continues on with his discussion:

Raphael Bostic, USC: You are saying that some places you’re expecting, on aggregate, to go negative?

Simon: Well, it’s very unusual for them not to.

Bostic: So which places do you think?

Simon: Places that specifically worry us? San Diego worries us.

Bostic: Particularly in the condo market. I agree with that.

Simon: San Diego earliest went to the affordability product, interest-only mortgages most heavily, earliest. Biggest number of investors, earliest. And it’s probably just further along in the cycle.

Ah, good ol' San Diego, another fine distinction for my fair city... I hope San Diego is the first to crash and that prices quickly return to levels where ordinary people can afford houses without perilous loan products. It saddens me that my neighbors are becoming the f@cked borrowers SoCalMtgGuy talks about. (Ex: a coworker who bought a condo about 16 months ago using a 1-year fixed ARM, and is now having to "cut back" his lifestyle because of his increased mortgage costs...)

Another F@CKed Borrower

Have you seen Another F*CKed Borrower? It's a blog from a mortgage "insider" and, among other things, details real-life borrowers and examines the lending process from the lender's perspective. What's doubly neat is that the blog's author, SoCalMtgGuy, is also from San Diego, so there are a number of discussions on local real estate/borrowers.

Be sure to check out the blog entry, Let's play "Should I buy... or wait?" It's a look at whether or not a reader who is considering buying now would be better off making his purchase or holding off and continuing to rent. SoCalMtgGuy does a great job dissecting the issues and concerns at hand. The answer is not too hard to arrive at, though, seeing as we're at the top of the market now, the reader is renting for a great price, and the reader's rental is currently larger and in a better part of town than the home he's looking at.

Will the reader listen to SoCalMtgGuy's advice and hold off on buying? Or will house fever push good judgement aside? I hope the reader lets the blogosphere know!

Stopped by an Open House Today

My wife and I stopped by an open house today for a condo conversion project that's been under the works for over a year. (My wife walks past the project each day on her way to work, so she was interested in perusing the open house.) Prior to the conversion, the place was a typical late 1970s/early 1980s apartment complex, which seem quite numerous around our neighborhood.

The open house had a half dozen realtors there, showing three of the 30 or so units. There was also some live music, a soloist strumming some Mexican guitar music. The units had been improved nicely, with new paint, kitchens, hardwood floors, granite countertops, free wifi, new plumbing, new fixtures, etc., etc. All in all, a nice job, they've spent a lot of time and energy on the project as a whole, as evidenced by my wife's daily walk to work.

While the conversion was nice, there were a few problems that would definitely sour me:

• The location
• The price per sq. ft.
• The layout/age of the building

First off, the project was located one block from the road in town littered with bars and tatoo parlors, and three blocks from the beach, cramed between two other apartment complexes and a busy alley. To put it another way, you weren't going to get any sleep during the weekends, especially in the summer months. (My wife and I live on a cul-de-sac street, and we still get enough noise, especially in the summer, to wake me usually at least once a night during the weekends.)

The prices started in the low $300s for the 450 sq. ft. efficiency unit on street level.
That's close to $750 per square foot. And the efficiency we toured was right on the street level with its back window facing the alley (meaning that across the alley are the backs of the bars that are open to 2:00 AM each night). The largest units available were one bedroom and neared 1,000 sq. ft., although I'm not sure what their prices were.

Finally, the conversion, while well done, was on an older building. Walking around the units the floorboards creeked much like my parent's home that was built in the 70s. Not necessarily the sign of defective construction or termites or whatnot, but it's kind of unsettling to be dropping that kind of money for a seemingly "new" place. It's important to keep in mind that you're really buying a renovated interior of an old apartment complex.

This was one of dozens of open houses in the neighborhood. On our walk there, we passed the sign flippers for the conversion that's offering a free car if you buy a condo. I assumed we wouldn't see any potential buyers, but while we were touring the open houses we saw five or six others checking out the open units as well.

How Can They Say These Things in Good Conscience?

Lydia Puller's article on the Bay Area Business Women website is titled Should You Buy Before the Housing Bubble Bursts? That's kind of like asking, "Should you pay retail before the sale begins next week?" Um, sure, I guess, if you like spending more than needed. What's odd about this piece of trash article is that the oxymoronic title indicates that there is a housing bubble, but then Ms. Puller quickly comments:

There will always be a demand for housing and in the past 10 years real estate has grown at a rate of 10 percent per year. ... According to the National Association of Realtors, home prices are in no danger of falling. The housing market, nationally and in California, is expected to remain strong. The market may slow down and level off and even Alan Greenspan of the Federal Reserve Board says the market will inevitably simmer down — but the housing bubble will not burst, property prices will not go down 10-20 percent, and the sky is not falling.

Ah, so the NAR says home prices are in no danger of falling... kind of like how that used car salesman tells me a quality '96 Mecury Sable will be the best 'investment' I can make for my automotive future. What's a bit sickening is that in this article Ms. Puller does not identify herself as a real-estate agent, but this is obvious by her rhetoric and her choice to ignore reality. In fact, a quick Google search on "Lydia Puller" returns as the #1 hit LydiaPuller.com, which indicates that Ms. Puller is an agent with Alain Pinel Realtors.

Take a moment to read the article, and I think you'll have either one of two possible reactions (if not both, one after the other). You may just kind of laugh this garbage off, figuring that a realtor is really just a salesman and a salesman will say whatever they need to make the sale. But you may also start to feel disgust. How can Ms. Pullman make these statements? The article talks about buying multiple rental properties and it being pitched to first-time homebuyers and single women/mothers. Isn't this an unconscionable sales pitch to make, in a sense? Yeah, yeah, caveat emptor, but I still think karma frowns on people who are pimping an overpriced and risky "investment" to a group of people who are least likely to be able to afford it.

Things Beginning to Crack

One thing that's frustrating for me in watching the housing bubble's growth and eventual burst is that with real estate the cycle is almost glacial. Working in the technology field, I'm used to seeing things change rapidly; in the business side, weeks or months can make or break a business. But with the real estate market, it takes months or even years for changes to occur.

There have always been foretelling signs of a real estate bubble: out of whack income to mortgage ratios, alarming number of interest-only and neg-am mortgages, a disparity between home ownership costs and rents, the meteoric rise in home prices, the fact that only one in ten San Diegan residents can afford to buy a median priced home, and on and on. These signs, however, did not point to the end of the bubble, they just highlighted that we were in an unsustainable economic bubble, a party that was destined to come to an end eventually.

Earlier in the year, signs started emerging that the wild ride up was over (at least for the San Diego area). Properties were languishing on the market, taking months to sell. Sellers were listing at one number, but eventually selling at a lower number. Compare this to the environment a couple years back. Back in 2003 a friend of mine sold his condo - he listed his unit on a Friday for a fair price and had a three offers on the following Monday, all over his asking price.

Over the past couple of months the cracks in the bubble have continued to widen. It's clear now that sellers and real estate agents are more desperate. There are now cold calls, sign-flippers, real estate agents going months without a sale, increasing mortgage defaults, and languishing sales. An article in Realty Times by Bob Schwartz, titled San Diego Real Estate - A Trend to Go National?, enumerates the woes in the San Diego market and laments that these effects will likely be seen elsewhere in the nation sooner than later. Bob succinctly notes: "The grand opening long buyer lines, multiple offers, offers above the asking price and homes selling within days of being listed are just fond memories now. However, due to the huge home appreciation all San Diego real estate has seen, with the average home up 100 percent in the past 5 years, combined with the boom in 100 percent adjustable/interest only loans, the stage is set for what is sure to be mind-numbing depreciation."

The meltdown continues, but not at a pace I'd like to see. I guess I just need to be more patient and understand that the depreciation we're seeing now and will continue to see will not be a flash in the pan, but something that stretches over years.